Borrowers tap hot ESG demand to sell green bonds at a premium

Governments and companies raising funds through green debt are benefiting from lower borrowing costs, a so-called “greenium”, in the latest sign of investors’ ravenous demand for sustainable assets.

The premium in price these deals command highlights the swift growth in the market for debt that is labelled green because it funds spending that is meant to support climate or environmental goals.

“Everything with a green label is basically being bought,” said Mitch Reznick, head of sustainable fixed income at Federated Hermes.

Germany’s debut green government bond, which is closely tracked because the country’s debt market is considered a regional benchmark, has consistently traded at a premium in price to its conventional counterpart since it was issued in September. The yield on the green Bund is now about 0.05 percentage points lower than its conventional “twin”, an indication that investors are willing to pay more to hold the environmentally friendly debt.

Italy’s first sovereign green bond also priced last month at a slight premium compared with typical Italian debt with a similar maturity, analysts said.

“The greenium is now a very well established concept,” said Philip Brown, global head of public sector and sustainable debt capital markets at Citi. At banks, even “the most cynical syndicate manager” arranging bond sales would build a greenium into their pricing expectations, he added.

The greenium can be hard to analyse, because issuers do not typically sell green and conventional bonds with the same characteristics at the same time. But in a study of environmental debt issued in the second half of 2020, the Climate Bond Initiative found “increasing signs” of the phenomenon.

The analysis of 54 corporate and government green bonds, which collectively raised $62.5bn, found the level of demand from investors was greater than for regular equivalents. The CBI also found many of the bonds priced at more favourable borrowing costs than would have been expected for issues with similar maturity.

“The sources of [green bond] demand are increasing more rapidly than the sources of supply,” making pricing more competitive, said Caroline Harrison, senior research analyst at the CBI.

Given pricing typically hinges on an issuer’s ability to repay its debts, as well as market dynamics such as interest rates, the more favourable terms borrowers receive solely for the green label might represent irrational lending rates, some analysts said.

“It’s not an alarming risk at this point,” but the need to fulfil sustainability mandates could be driving mispricing, said Reznick. “It’s not that credit risk is being ignored; it’s not being as precisely priced.” 

Others worry over whether the green label always lives up to its promises.

“Green bonds are used by borrowers to cash in on lower borrowing costs,” said Mark Dowding, chief investment officer at BlueBay Asset Management. “I don’t see what difference that’s making at all. I’m not sure that’s making the impact that people would like to see.” Instead, he said, it could be more worthwhile to refuse to buy certain issuers’ debt or to encourage borrowers into setting tougher sustainability standards.

Colin Reedie, co-head of global fixed income at Legal & General Investment Management, said imbalances of supply and demand had led to unstable market bubbles in the past, although he added he did not believe the green debt market was approaching bubble territory.

Green bonds sold in the primary market tend to price at yields 0.1-0.15 percentage points lower than conventional bonds, which was still “not insignificant” given the relatively low rate environment, said Reedie.

“Our policy is to treat green bonds no differently from vanilla bonds from the same issuer,” given the risk of default is the same regardless of what the money is funding, he added.

The possibility of a green bond bubble is concerning from a risk perspective because it would damage the credibility of an important and relatively new market, said Emre Tiftik, director of sustainability research at the Institute of International Finance.

But he pointed out that valuations had been stretched across debt markets in general because of enormous volumes of pandemic-related central bank support. “If there is a [debt] bubble, it’s not driven by green bonds,” he said.

Some analysts said they expected the greenium to disappear over time, as supply and demand evened out and responsible investing became the norm, rather than an investment category. 

Dominic Kini, credit and green bond strategist at HSBC, said sustainable debt was still in a growth phase, and the greenium was not “mispricing” but a function of supply and demand: a growing group of investors who were required, or wanted, to allocate capital to sustainable activities were competing for a limited pool of assets.

In the short term, with investors eyeing the prospect of rising inflation, the greenium could become more pronounced, said Brown at Citi.

Bondholders have already started rebalancing portfolios and selling out of highly rated debt, sending prices lower, as the global economy recovers from the coronavirus shock. But green bonds are likely to be “stickier” than vanilla bonds, and not among the first assets to be sold given their relative scarcity, he said. “We will see this greenium become more structural in the secondary market.”